How Bad Money Drives Out Good: Gresham’s Law Explained
Gresham’s Law states that “bad money drives out good money”. For instance, if there are two forms of money (suppose a gold coin and a silver coin) in circulation, the more valuable kind will disappear. This law was based on the composition of the minted money and the value of metals used.
This law is named after the financial adviser to Queen Elizabeth ?, Sir Thomas Gresham. The observation made by Gresham during the ‘Great Debasement’ and the advice laid out to the Queen gave rise to Gresham’s Law.
Good Money vs Bad Money
Good money refers to the currency with more intrinsic value whereas bad money (not counterfeit or unstable) has less intrinsic value. Both currencies are acceptable forms of money at par value by legal tender laws and can be used simultaneously. In this case, as people begin to discriminate between the two of them, they start paying invariably with the poorer one and hoarding the better money, thereby taking the good money out of circulation.
Cheaper money tends to crowd out dearer as:
- the purchases would be made with the cheaper money,
- the dearer one would be hoarded,
- or else used in foreign exchange.
Gresham’s Law in the Bimetallic System
Initially, the law was inspired by the ‘Great Debasement’ during the bimetallic system. A bimetallic monetary system is based on the use of two metals (traditionally gold and silver) as currencies at a fixed ratio to each other under the legal tender.
Let’s understand the law in the bimetallic system by an example. Assume that the world price ratio for silver to gold is 15.12:1, which means that 15.12 units of silver would buy 1 unit of gold and vice versa. Both gold and silver can operate as a currency in a bimetallic system. If in a country, the mint fixes the silver to gold ratio at 15:1 without influencing the world price ratio, then the world price for gold is higher than in the country.
Now, the gold will leave circulation as people will hoard or export gold for a higher price and, silver tends to overflow and this leads to the overvaluation of silver and undervaluation of gold. Hence, silver and gold become bad and good money respectively.
Limitations: Inapplicability of Gresham’s Law
Without effective enforcement of the laws of legal tender, the good money would crowd out the bad because individuals could just refuse to accept less-valuable money as means to pay for transactions.
In short, absent a law on legal tender, the merchant would accept nothing other than money with some specific value (good money), but having legal tender laws in place would force the purchaser to only offer money of lower value for goods (bad money) since creditors would have to accept that kind of money at face value.
In today’s modern times Gresham’s Law loses its significance under a paper money system. The coins of different metals in the bimetallic system could be melted down, exported abroad, and could be sold by weight, but that cannot happen in a paper money standard.
What we can learn today from Gresham’s Law is the analogy to the competing standards in the industry.
If there is indifference in a certain industry and they do not create a policy to keep the system away from bad behavior, this will lead the superior standard to disappear in presence of an inferior standard, in the same way as bad money drives out good.
The goal is to avoid such systems where good behavior cannot win.
Author : Chelsi
Date : 21-Jul-2022